Can you use the equity in your primary residence to purchase an investment property? In short, YES! But, bare in mind that there are pros and cons to doing this. Overall, I believe it is a solid option for buying an investment property. Read on to learn more.
What is Home Equity?
Home equity is the difference in amount you owe on your home and what your home is worth. To find out how much equity you have, ask a Realtor to give you a value estimate for your home or you can compare your home to recent home sales in close proximity to you. Be sure to only compare your home to those most similar in size, age, and condition to get the most accurate market value. Now that you have a pretty good idea of what your home is worth, deduct what you owe your lender from that. Voilà, that is your equity.
How to get your hands on your home’s equity
Home equity loan: This is a second loan separate from your mortgage that allows you to borrow against the equity in your home. Home equity loans are considered a 2nd mortgage and for that reason tend to have higher interest rates than first mortgages.
Restrictions for home equity loan
It’s unlikely that a lender will allow you to borrow 100% of your equity. Usually lenders will loan 75% to 90% of the value of the home. However, if you have a VA loan, you can borrow up to 100% of your homes value.
Once you close on the home equity loan, you will receive a lump sum payment from your lender that you are expected to repay.
When you do a cash-out refinance, you are replacing your existing mortgage with a new one. If you’ve refinanced in the past, maybe for a better interest rate. The process is similar, except that you are opting to increase your loan amount and take cash out of your home. You’ll be pocketing the difference between your current loan balance and and your new loan amount.
Similar to a home equity loan, lenders will typically only allow for a 75% to 90% loan-to-value (LTV) with VA loans being the exception, as they will allow for a 100% LTV ratio.
Things to keep in mind:
Debt-to-Income Ratio: If you don’t have enough equity and cash set aside to buy an investment property without getting an investment loan. Then you’ll need to be sure that when you take out a home equity loan or increase your current mortgage amount with a cash-out refi that you’re debt to income (DTI) ratio isn’t then too high to qualify. Usually lenders prefer 36% DTI or less, however, some lenders will go as high as 50% depending on credit score, down payment, and loan option.
Before taking out the home’s equity, find out what loan option for your investment property would be best for you and discuss a hypothetical scenario with your lender to find out what it would look like if you cashed out on your home equity to put down on an investment property.
Using your equity funds
Budget: Get a pre-approval from a lender for the investment property. This is a VERY important step in the process, because:
- You’ll know what you can afford
- Pre-approval letter strengthens your offer, because it shows the seller that you are serious and have the means to close.
- Your loan will likely close quicker because the lender is already through a big part of the loan approval process.
Plan on having 15%-25% or more of the purchase price set aside for a down payment and closing costs.
Determine Profitability of a property:
Before making an offer on a home, it is important to calculate the properties profitability. A good rule of thumb is the 1% rule, meaning that the monthly rent you charge, must be equal to or greater than 1% of the purchase price.
For example: Let’s say you bought a home for $200,000:
$200,000 x 0.01 = $2,000
Based on this rule, you will want a mortgage payment of less than $2,000 and charge your tenant $2,000/month or greater in rent to make a decent profit.
This rule helps when reviewing income reports from an investment property that is for sale. Let’s say an investment property is listed at $200,000 and is receiving $2200 in rent each month. Per the 1% rule, this is a sound investment decision.
If you found that the rent being charged on a home listed $200,000 is only $1800/month. Then it does not pass the 1% rule. In this case, you should move on to a more profitable property or submit an offer no more than $180,000 based on the 1% rule.
Another option for determining profitability is the “Gross Rent Multiplier.”
*Note that this is a screening metric to compare properties to decide which to move forward on, at which point you should do your due diligence in determining expenses, cap ex, taxes, etc.
The gross rent multiplier (GRM) is a way investors compare rental property opportunities in a given market. The GRM gives a ratio of the property’s market value over it’s annual gross rental income.
Example: $200,000 fair market value / $36,000 Gross rental income = 5.5 GRM.
What is considered a good GRM?
This depends on the type of rental market your in. Are you looking more for a short term rental, long term tenant, and market area. You’ll want to aim for a GRM between 4 and 7. A lower GRM means it’ll take less time to pay off the rental property.
The bottom line:
Cashing out your home equity to buy an investment property is great option if you don’t quite have the 15%-25% to put down. Know your budget, DTI, and how to calculate a good investment opportunity before shopping around and making an offer. You can use the GRM method to “rank” properties to find out if a property makes sense as an investment and the 1% rule to will help narrow the search even further. This will help save time, as you don’t want to dig in the all of the numbers on every property you see, only those that rank high using these methods.
Reach out to a few different lenders that offer investment loans to find out their qualifiers, terms, rates, etc. It is a good rule of thumb to talk with at least 2 to 3 lenders before making a decision.
Choose a realtor that is investor friendly, as they will know how to screen properties for you and know the rental market in which you are searching in.
Are you in the Charlotte North Carolina area? Looking to purchase an investment property? I’ve got you covered. Send me a message letting me know what you’re looking for and a date/time that works for you to discuss. OR simply pick a time on my calendar here. You can also search real estate listings here.